How to buy a business

Session 12: Buying Businesses

OBJECTIVE: Buying an existing business can offer advantages over organic expansion. In this session, you will learn how to evaluate the opportunities and risks associated with expansion through acquisition.

You know the businessIn many ways buying an existing business can offer advantages over internal expansion. You already know where the pitfalls and opportunities lie. You can "add on" a business without any learning process and can make improvements based on your own operations.

Economies of scaleAcquisitions of companies in your own field will strengthen your buying power and spread your fixed costs over a high level of sales. Waste Management is a good example of successful growth through acquisitions. This multi-billion dollar enterprise was built by acquiring hundreds of companies in the waste business.

Profit centers are already in placeAcquiring businesses is inherently less risk than starting from scratch. Everything is already in place: the sales, earnings, and organization. All these are uncertainties when starting an operation from scratch.

Expand geographicallyGeographic expansion increases your customer base and, therefore, sales. It also opens up the potential for more potential advertising media that would be inefficient in a limited area.

Better positioned to evaluate intrinsic valuePlacing an accurate value on an acquisition will be crucial when investing your retained earnings. We recommend that calculating intrinsic value is used as the basic tool. Operating companies with a history of earnings plus good prospects of future earnings will make the calculation of its intrinsic value more accurate. See "evaluation methods" later in this session.

Vertically integrateOn the supply side, vertical integration includes acquiring sources of supply in order to lower your costs and insure quality standards. On the operating side, it might mean acquiring an IT firm to establish your own Internet technology department. On the marketing side, it may mean acquiring a distributor in your marketing chain. Session 9 Vertical Integration will furnish complete information on the advantages, risks and how to evaluate vertical integration.

Complement your existing product linesIf you are manufacturing golf clubs, would it be appropriate to also sell golf bags and other golf equipment? Here are two examples of "add-on" acquisitions:

Quaker Oats' acquisition of Snapple became a textbook example of what can go wrong in an "add on" merger. The corporate cultures were altogether different. Quaker Oats upset the distribution network, let go the sales force, redesigned packaging and advertising campaigns, all with disastrous results. Quaker Oats sold Snapple three years later at a loss of approximately $400 million.

Proctor & Gamble's acquisition of Natura Pet Products is an example of a positive "add on" acquisition where P&G's existing lines of pet foods will be broadened to include the holistic and natural segment of the market. The localized business of Natura will also be scaled up to world-wide marketing opportunities.

Branding mistakesPurchasing a company whose product is highly regarded poses the question: "Should we change their branding to our own?" Most acquiring firms take great pride in their own brand names and generally will change an acquired name to their own. This can be either a good or bad idea depending on the circumstances. Here are examples:

Do you think an acquirer of Hershey Chocolate would change the name from Hershey to their own brand? Probably not...an easy decision.

Building a brand name is expensive and takes a lot of time. Four years after Macy's acquired Marshall Field's store in Chicago, 81% of Chicago shoppers still preferred the Field's name over Macy's.

Yum Yum Donuts acquired Winchell's Donuts, a famous name in donuts. Yum Yum's management resisted the temptation to change the name to Yum Yum. Why discard a great reputation and name that had taken generations to build?

Integrating the businessThere will always be challenges when integrating an acquired business. For example labor issues may need to be resolved or operating cultures, spending disciplines, and lines of authority. In your due-diligence process, make a check-list of all issues in which the cultures and business practices of you and the acquirer differ and work out all potential problems before closing.

Failure to clear seller's potential liabilitiesAny company you acquire will have some problems and possibly unrecorded liabilities. Usually, the seller will be anxious to disclose undocumented problems because if they don't, non-disclosure could expose them to the potential of later litigation. So whenever the seller discloses any unrecorded liabilities or problems, slow down and be careful to take the time to have them fully resolved.

Inadequate evaluation of retaining the managementIt would be a mistake not to carefully analyze whether or not to retain the management of the acquired firm. Here are some considerations:

Retain the management

In some businesses that are relationship-driven, retaining managers and their client networks would be crucial to the success of the business.

You may not be able to, or desire to, supply management. You will need to have a clear agreement that management will stay on.

In some cases, the seller may be a great manager and getting great satisfaction from the challenges of the job.

Install your own management

You may be able to install your own managers with no loss to the business.

Enhancement of the business by replacing poor management could become part of your acquisition strategy.

A review of Session 2 Getting Your Team in Place can provide a business plan outline for the operation of an acquired business.

The seller's suppliers may not want to sell to youLet's assume you are purchasing a competitor. Part of the reason is your wish to add their highly desirable "widget" line of goods to your own line. You will need to get assurance from the company making "widgets" that they will continue to sell to you. If you close your purchase without this assurance and "widget" company declines to sell to you, you have wasted what you paid to get the line.

Over-leveragingThe biggest risk in expanding or making acquisitions is incurring too much debt, either from the seller or other sources of financing. Business leverage refers to the use of borrowed funds to accelerate growth and increase the rate of return on an investment such as purchasing a business. For example, if an acquired business can generate a 20% annual return and the cost of the borrowing is 5%, the potential earnings are magnified.

But leverage is a double-edged sword that is a powerful tool during good times but can quickly become your worst enemy during bad times. You may encounter temptations to over-leverage when purchasing a business. If you are offered favorable financing from a seller, keep in mind he may not be too concerned with your risk because if you can't make the payments he will put you in default and take the business back.

Whenever you hear about companies going into bankruptcy, there will almost always be the same reason cited: "Our revenues dropped because of the bad economy." But if you investigate closely you will probably find that the company had launched a capital project or acquisition by borrowing money and were unable to pay it back....nothing to do with a bad economy. In bad times, companies without debt can simply continue to reduce the cost to maintain a balanced cash flow.

The worst part of incurring a high level of borrowing lies in the fact that if for any reasons, including unexpected business downturns, you are unable to service, replace or renew the debt, you will run the risk of losing your company. You could be betting the company that unforeseen external or internal adversities will not occur.

So as you grow, you have choices:

Don't borrow at all. Build through the use of retained earnings.

Restrict borrowing within two very conservative limits:

Restrict the annual debt service to a small fraction of your conservative annual cash flow.

Borrow long-term and pay off short-term. If you plan to repay in 3 years borrow for 6 years (but pay off in 3 years).

Inadequate accounting controlsIt is possible that your existing accounting system and internal controls are not adequate to manage the larger organization. Review the overall needs with your CPA before closing and have necessary systems and people in place.

Your acquisition program should include having your annual financial statements audited. This highest level of accounting scrutiny is expensive but can be invaluable in an acquisition program:

Description of the modelWarren Buffett's remarkable success as chairman of Berkshire Hathaway provides a potential acquisition strategy for some entrepreneurs. It requires expert judgment in evaluating acquired management and the intrinsic value of potential acquisitions. The overall strategy is to acquire businesses with high intrinsic values at attractive prices where the sellers wish to stay on as operating managers.

Acquisition criteriaSome important considerations:

The acquired company must have a history of earnings over a period of years.

Be a business you understand.

Businesses earning good returns on equity while employing little or no debt.

Outstanding operating management must desire to stay and manage the business.

The acquired business does not have to be in your own industry.

It should not require large amounts of retained earnings to grow.

You, as the acquiring firm, will control all capital allocations including the use of the acquired company's retained earnings to purchase other companies.

Management rolesYour firm must be very good at two distinctly different management skills:

The oversight and nurturing of the acquired companies.

Making wise decisions in the allocation of capital.

Warning labelWarren Buffett is one of the most brilliant businessmen in history. In other words, be warned that this is a difficult growth model to emulate. It requires uncommon abilities in the evaluation of businesses and their managers.

The three key external players will be your lawyer, CPA, and banker. Both your lawyer and CPA should be engaged in acquisition practice and tax laws. You should also bring in your key department heads such as your marketing manager, chief financial officer, and any key advisors.

Establishing the priceIn any purchase transaction (and buying a business will be a big one) you will need to establish that the price you pay is justified. If you are already in the business that you are acquiring, your evaluations should be better qualified than the estimates of outsiders.

To follow the desirable rule "buy low, sell high" you should buy a business for less than its valuation and sell it for more than its valuation...but you must know how to establish "valuation!" There are three guidelines to keep in mind:

It is better to buy a great business at a fair price than a fair business at a great price.

It is better to be approximately right than absolutely wrong in your pricing evaluation.

It is better to buy a great business with bad management than a bad business with great management.

Placing a value on a business can be determined in a number of ways. In order to lessen the risk of being absolutely wrong in pricing, we recommend that you establish valuation by more than one or two methods. Here are methods available to you:

SalesThe standard valuation of a donut shop is weekly sales. As weekly sales increase, the bottom line earnings increase more rapidly because fixed costs are already covered. For example, once a fixed cost such as rent is paid for, higher sales will produce an even higher percentage of profit. A profit of a $20,000 per week shop will be more than twice that of the $10,000 per week store if the fixed costs are the same. Experienced buyers will pay more than twice as much for the $20,000 store than they would for the $10,000 per week store.

EarningsThe earnings of a business can sometimes be hard to determine. This could result from inadequate accounting records. Accounting transactions might be erroneously booked as earnings. Or some cash sales (and, therefore, earnings) may not be recorded at all. It may be necessary to stand by the cash register for an extended period of time to determine real sales and make an estimate of earnings.

Return on capitalReturn on capital is sometimes referred to as return on investment or ROI. This is a mathematical equation: net earnings divided by the rate of return establishes the valuation. If you are buying a business earning $100,000 per year after taxes and expect to receive 20% return, your purchase price could be around $500,000. ROI will vary widely in different industries. So it will be helpful to learn what the norm is for the business you are interested in.

Intrinsic valueWhen you buy a business, what you are really paying for is the present value of the sum of all of its future earnings. Intrinsic value is a mathematical calculation which converts all future earnings into their present value. One method is to create a ten year spreadsheet of the estimated future year-by-year earnings and convert each of these, along with a residual long-term value, to an overall present value. This becomes the "intrinsic value" of the business. Search engines may offer programmed solutions to determining intrinsic value and we strongly recommended you become familiar with this important tool.

Growth potentialThe measurement of a growth potential situation can be numerically measured by the intrinsic valuation calculation because your future projections will include your estimates of growth. Of course, the result will be a reflection of your accuracy in projecting future numbers.

In small business sales, the seller is usually the source of part of the financing. Unless you have a strong banking relationship, the seller will be your number one source for financing. But don't be tempted to buy a business because of a seller's willingness to finance the purchase. Stay within the leverage limitations referred to earlier in this session under "Risks."

Outline to your seller exactly how you plan to repay his loan including your anticipated debt-to-earnings ratio.

Sometimes sellers will look for a personal guarantee or additional security based on assets outside your business.

If you secure financing from both your bank and the seller, the seller's financing will most likely be subordinated to the bank loan.

Your lawyer and CPA can strategize with you to design the overall financing package.

Unless you are also buying the property, the lease is probably the most important document you will evaluate. Review Session 10 Location and Leasing in the Starting a Business course. The following are the most relevant lease items:

The term or length of the base lease.

Options to the base lease term.

A rent that is affordable and competitive.

How often and how much are the adjustments to the base rent?

NNN charges.

Assignment provisions.

The Landlord's contributions to the improvements, if a new business.

What is the quality of the improvements and fixtures: will they need replacement?

What is the quality and size of the inventory: is it overstocked with obsolete items?

What is the condition and amount of the receivables: are they collectible?

If I am to buy the payables, how current are they and what is the accurate total?

Is there an order backlog?

How strong are customer relationships: the goodwill you will pay for?

Is the primary marketplace stable or changing?

Does the business have, or can it obtain, all necessary government approvals and licenses? Are there any exorbitant fees?